Chapter 3. Learning Objectives Principles Used in This Chapter 1. An Overview of the Firm s Financial Statements

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1 Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows Agenda Learning Objectives Principles Used in This Chapter 1. An Overview of the Firm s Financial Statements 2. The Income Statement 3. Corporate Taxes 4. The Balance Sheet 5. The Cash Flow Statement Learning Objectives 1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. 2. Evaluate firm profitability using the income statement. 3. Estimate a firm s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate. 1

2 Introduction Use the balance sheet to describe a firm s investments in assets and the way it has financed them. Identify the sources and uses of cash flow for a firm using the firm s Cash Flow Statement. Principles Used in This Chapter Principle 1: Money Has a Time Value. We need to recognize that financial statements do not adjust for time value of money. Principles Used in This Chapter Principle 3: Cash Flows Are the Source of Value. Financial statements provide an important starting point in determining the firm s cash flow. We should be able to distinguish between reported earnings and cash flow. It is possible for a firm to report positive earnings but have no cash! 2

3 Principles Used in This Chapter Principle 4: Market Prices Reflect Information. Firm s financial statements provide important information that is used by investors in forming expectations about firm s future prospects and subsequently, the market prices. An Overview of the Firm s Financial Statements Basic Financial Statements Following four types of financial statements are mandated by the accounting and financial regulatory authorities: 1. Income statement 2. Balance sheet 3. Cash flow statement 4. Statement of shareholder s equity 3

4 Basic Financial Statements 1. Income Statement: An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months): Revenue, Expenses, and Profit. Basic Financial Statements 2. Balance sheet: Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010) Assets (value of what the firm owns), Liabilities (value of firm s debts), and Shareholder s equity (the money invested by the company owners). Basic Financial Statements 3. Cash flow statement: It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months). 4

5 Basic Financial Statements 4. Statement of shareholder s equity: It provides a detailed account of the firm s activities in the following accounts over a period of time (for example, last six months): Common stock account, Preferred stock account, Retained earnings account, and Changes to owner s equity. Why Study Financial Statements? Analyzing a firm s financial statement can help managers carry out three important tasks: 1. Assess current performance through financial statement analysis, 2. Monitor and control operations, and 3. Forecast future performance. Why Study Financial Statements? 1. Financial statement analysis: Financial statement analysis allows us to assess the present financial condition of a firm. Chapter 4 introduces the tools and techniques used to carry out financial statement analysis. 5

6 Why Study Financial Statements? 2. Financial control: Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firm s operations. For example, a creditor may analyze a firm s financial statements to decide whether or not to renew company s loan. Why Study Financial Statements? 3. Financial forecasting and planning: Financial planning models are typically built using the financial statements. Financial planning is covered in chapter 17. What are the Accounting Principles Used to Prepare Financial Statements? The following three fundamental principles are adhered to by accountants when preparing financial statements: 1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements. 6

7 What are the Accounting Principles Used to Prepare Financial Statements? 1. The revenue recognition principle: It states that the revenue should be included in the firm s income statement for the period in which: Its goods and services were e exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash. What are the Accounting Principles Used to Prepare Financial Statements? 2. The matching principle: This principle determines whether specific costs or expenses can be attributed to this period s revenues. The expenses are matched with the revenues en es they helped produce. For example, employees salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid. What are the Accounting Principles Used to Prepare Financial Statements? 3. The historical cost principle: This principle provides the basis for determining the dollar values the firm reports in its balance sheet. Most assets and liabilities are reported in the firm s financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities. 7

8 Financial Statements An Income Statement Income statement can be expressed as follows: Revenues (or Sales) Expenses = Profits An Income Statement Sales Minus Cost of Goods Sold = Gross Profit Minus Operating Expenses Selling expenses General and Administrative expenses Depreciation and Amortization Expense = Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes = Net income (EAT) EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes 8

9 Sample Income Statement Checkpoint 3.1 Constructing an Income Statement Use the following information to construct an income statement for Gap, Inc. (GPS). The Gap is a specialty retailing company that sells clothing, accessories, and personal care products under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brand names. Use the scrambled information below to calculate the firm s gross profits, operating income, and net income for the year ended January 31, Calculate the firm s earnings per share and dividends per share. Checkpoint 3.1 9

10 The Balance Sheet The balance sheet provides a snapshot of the firm s financial position on a specific date. The balance sheet is defined by the following equation: Total Assets = Total Liabilities + Total Shareholder s Equity The Balance Sheet Total assets represents the resources owned by the firm. Total liabilities represent the total amount of money the firm owes its creditors Total shareholders equity refers to the difference in the value of the firm s total assets and the firm s total liabilities. The Balance Sheet 10

11 Step 1: Picture the Problem Current Assets Cash Accounts Receivable Inventories Other current assets Total current assets Current Liabilities Accounts payable Short-term debt Other current liabilities Total current liabilities Long-term (fixed) assets Long-term Liabilities Gross PPE Long-term debt Less: Accumulated depreciation Net property, plant and equip. Owner s Equity Par value of common stock Other long-term assets Paid-in-capital Retained earnings Total long-term assets Total equity Total Assets Total Liabilities and Owners equity The Cash Flow Statement The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash. Cash Flow Analysis Change in cash balance = Sources of cash Use of Cash = $216 - $ = -$4.50 Sources of Cash Uses of Cash Increase in Accounts Payable Increase in Accounts Receivable = $4.50 $22.50 Increase in long-term debt =$51.75 Increase in retained earnings = $ Increase in inventory = $ Increase in net plant and equipment = $40.50 Total Sources of cash = $ Decrease in short-term notes = $9 Total Uses of cash = $

12 Cash Flow Analysis Summary Sources of Cash Decrease in an asset account Increase in a liability account Increase in an owner s equity account Uses of Cash Increase in an asset account Decrease in a liability account Decrease in an owners equity account 12

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